Contagion: Default Probabilities Blow Out Right Across Europe

Look at this chart of the sovereign credit default swap wideners today. Every single name is European. The only one with a sub-10% default possibility is Sweden, and they are not in the euro zone. That tells you something, doesn’t it? I think Warren Buffett is on to something.

I like CDS as a gauge of market distress. For example, Belgian, French and Spanish CDS are at record highs. That tells you contagion is getting worse.

Imagine life insurance contracts that wouldn’t pay off if officials declared heart attacks to be “voluntary.” Welcome to the world of sovereign credit default swaps, or CDSs. When the Greek debt deal was announced on October 27, the eurozone leadership insisted that the banks were taking a 50% write-down “voluntarily,” meaning that Greek CDS contracts would not be triggered. This was done to protect official creditors like the ECB and IMF, to avoid rewarding speculators, and to prevent possible financial contagion. In response, Greek CDS prices plunged 20 percentage points. Policymakers didn’t seem to care, but they should.

I agree 100%.

CFR also believes we should kill sovereign CDS off. CDS in general were called weapons of financial mass destruction for a reason. SO I am sympathetic to the concept of neutering them they way the Europeans did. However, we see that doing so has had negative unintended consequences. Trying to shoehorn a 50% haircut for private sector creditors into a non-default event is crazy. There was nothing voluntary about it since the Troika and ECB didn’t take cuts. These CDS are now almost useless except as a fear gauge. You might as well sell euro paper now and ask questions later.

The best way to get rid of CDS is to regulate them tightly – ban naked CDS, ban future sovereign CDS – and slowly strangle the market until existing contracts expire. CFR agrees:

Given the permanent political distortion that Europe has introduced into the sovereign CDS market, it would be best now if the market could simply be shuttered.

Source: CMA

This post originally appeared at Credit Writedowns and is reproduced with permission.

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